As Tax Reform legislation works its way through Congress, we’ve mostly heard about its potential impact on personal or corporate income tax bills (i.e. “how will the GOP tax plan affect me?”) However, those involved in the financial reporting process should also be considering how potential tax reform could impact financial statements.
Per ASC Topic 740, changes to applicable tax law and rates should be accounted for in the period in which the changes are enacted. Such changes are enacted when the legislative process is complete, which in the United States would mean when a bill is signed by the President. This is the case even if the impact of the changes won’t occur until a future tax year. So, if legislation is passed by Congress and signed by the President before December 31, 2017, the impact of the changes would be recorded in the 2017 financial statements of a calendar year-end entity.
While the final format of any changes to the tax code is not currently known, the current drafts of the House of Representatives and Senate bills both contain changes to the current law in several significant areas related to corporate taxation. Three areas of significant change include overall rate reduction, treatment of taxes of foreign earnings, and changes to thresholds which would require an entity to become an accrual method tax payor. Let’s quickly discuss the accounting implications of each of these proposed changes.
Overall Rate Reduction
First, a change in enacted tax rates would require a revaluation of deferred tax assets and liabilities, which are currently measured for federal purposes at the currently enacted tax rate of 35%. The impact on the amounts of these deferred accounts could be significant for many companies and, per Topic 740, this impact would be included as a component of current income tax expense from continuing operations in a company’s financial statements, even if the impact on deferred taxes related to discontinued operations or other income tax items that are not accounted for through continuing operations (such as charges which are recorded as part of Other Comprehensive Income). Further, for companies that have recorded a valuation allowance against deferred tax assets (DTAs), a reduction in the value of those deferred tax assets could also trigger a revised assessment of the recoverability of those DTAs. In such circumstances, the entity would need to appropriately account for the changes in the valuation allowance as well.
Treatment of Taxes on Foreign Earnings
Another area where significant changes to recorded deferred tax liabilities (DTLs) or current income tax expense could occur is in the area of accounting for the impact of taxes on undistributed foreign earnings. These amounts are only taxable at the federal level when amounts are repatriated to the United States via a dividend. Companies anticipating this repatriation record deferred taxes on these amounts. So, as tax rates on these earnings change, the related DTLs will need to change as well.
However, many companies assert that these foreign earnings will never be repatriated to the United States. In doing this, they do not need to record deferred taxes on such earnings. However, with lower tax rates, companies may reconsider their repatriation plans, thus resulting in the need to record DTLs for such foreign earnings.
Additional, drafts of legislation also contain tax provisions that are designed to incentivize companies to repatriate previous earned foreign earnings for which the company has not provided deferred taxes. While the proposals may change, they currently include having the company pay a tax at a reduced rate on these foreign earnings that have not previously been repatriated, with this tax payable over a period of time. While the accounting for such a scheme would be based on the final format of the tax, such provisions would impact both current income tax expense and deferred taxes.
Changes to Which Companies Need to Become Accrual Basis Tax Payors
Lastly, draft legislation raises thresholds at which smaller companies need to become accrual basis tax payors as opposed to cash basis tax payors. As there is generally an economic advantage to being a cash basis tax payor, companies may want to consider their tax paying method. Generally the company would file IRS Form 3115 to request IRS approval for this change in tax paying method. Such a change usually results in a change in timing of tax payments, known as a Section 481 adjustment. If such an adjustment results in fewer taxes to be paid, the company can take the entire benefit immediately, while an adjustment that results in an increased tax liability would be paid over a period of years. Each of these adjustments would have an impact on both the current year tax expense and on recorded deferred taxes.
These are only some of the accounting impacts that would result from currently proposed changes to the corporate tax code under draft legislation. As the legislative process continues, these impacts may change and other impacts may result as changes are made to other sections of the corporate tax code. As you follow the path of the legislation, don’t forget to consider how tax reform could impact financial reporting, including the possible need for recognition in your company’s 2017 financial statements.
Want to learn more? Please join me for my upcoming Futurecast: A&A Today webinar on December 19th, where I will cover the accounting impact of changes to the tax code in greater detail, plus highlight other accounting items to consider for your 2017 year-end reporting.
Rich Daisley is Senior Director, Accounting and Financial Reporting Content for Surgent CPE. With over 26 years of experience in the accounting and auditing field, Mr. Daisley has worked in both the client service setting, mainly for PwC’s Capital Markets and Accounting Advisory Services Group and for PECO Energy’s Merger and Acquisition Group, and in the internal capacity setting as a course developer and facilitator creating leading training courses for PwC and Surgent. Rich lives in suburban Philadelphia.